INTERNATIONAL TAX NEWSLETTER

Issue # 10 - August 21, 2005
ITALY

RETROACTIVE APPLICATION OF INTEREST AND ROYALTIES EXEMPTION AND REIMBURSEMENT OF WITHHOLDING TAX COLLECTED DURING THE TRANSITORY PERIOD

As a result of the implementation in Italy of the EC interest and royalties directive (2003/49/CE) made by Legislative Decree n. 143 approved on May 30, 2005 and entered into force on August 10, 2005, interest and royalties paid or accrued to associated companies resident in a EC member state are exempt from Italian withholding tax as long as all requirements established for this purpose are satisfied. This topic was discussed in general terms in Issue # 9 of our International Tax Newsletter. According to article 3 of Legislative Decree 143, the exemption applies retroactively to interest and royalties accrued as of January 1, 2004 (the original deadline for implementing the EC directive), and paid between that date and the date of entry into force of the exemption (the “transitory period”). Here, we would like to focus our attention on the issue of reimbursement of withholding taxes collected on exempt interest and royalties paid during the transitory period. The Legislative Decree 143 contains two sets of rules that are not properly coordinated and entirely clear. On one side, article 4 provides that withholding taxes collected on exempt interest and royalties during the transitory period shall be reimbursed by the person who makes such interest and royalty payments. The payor shall be granted a tax credit for an amount equal to the amount of reimbursed withholding taxes that she will use to offset her own tax liability, according to the general rules (article 17 of Legislative Decree n. 241 of 1997). Literally, the provision refers to the person who makes interest and royalty payments, i.e. the person who is liable for the payment of interest or royalties at the time of the request of reimbursement of the withholding taxes. This person may be different from the person who made the payments on which the withholding taxes to be reimbursed were previously collected, as it happens whenever the arrangement from which the exempt interest and royalties arise has been assigned to a new borrower or licensee between the date the withholding tax was collected and the date the withholding tax must be reimbursed. Article 4 lacks to clarify whether interest would be due on the principal amount of the reimbursement, what the deadline for requesting and making the reimbursement would be and what type of documentation, if any, should be provided to the payor in order to obtain reimbursement. On the other side, article 2 of Legislative Decree 143 adds new provisions to article 38 of Presidential Decree n. 602 of 1973 that contains the general rules on refund of income taxes, according to which refund of withholding taxes collected on exempt interest and royalties is due within one year from the date of filing of the refund claim, the refund claim must be accompanied by adequate documentation evidencing that the requirements for the exemption are satisfied, and interest is due as of the expiration of the one-year time limit up to the actual date of payment of the refund. Articles 2 does not contain any cross-reference to article 4 (and vice versa). Therefore, it is not clear whether the rules of article 2 should apply to the special reimbursement procedure referred to in article 4, or, rather, they entitle the foreign taxpayer to apply for a refund of withholding taxes to the tax administration according to the general rule, as an alternative to special procedure of reimbursement off the withholding tax from the payor as provided for at article 4. This may be relevant when the payor who is responsible for the reimbursement no longer exists or is financially unable to pay it. Foreign taxpayers must be aware that any refund claim to the tax administration would be subject to the ordinary 48-month statute of limitation period (running from the date of collection of the withholding tax, regardless of when it was actually remitted to the tax administration).

Since the exemption was enacted with more than one year of delay with respect to the deadline originally set forth for implementing the EC directive, one effect of the provision of article 2 is that interest for the excess delay period is denied.

TAX ADMINISTRATION PROVIDES CLARIFICATIONS ON THE HOLDING PERIOD REQUIREMENT FOR THE PURPOSE OF ITALIAN DIVIDEND WITHHOLDING TAX EXEMPTION

Dividends paid by an Italian company to an associated company resident in another EC member state may be exempt from Italian withholding tax if certain requirements are met. The domestic statutory provision granting exemption from dividend withholding tax is set forth in article 27 bis of the Presidential Decree n. 600 of 1973, which implemented the EC parent-subsidiary directive (90/435/CEE). An associated company for this purpose is any company owning directly at least 25 per cent of the stock of the company that pays the dividend. The 25 per cent threshold has been reduced to 20 per cent for the taxable year 2005 as a result of various changes to the parent-subsidiary directive enacted with the directive 2003/123/CE, which should have been implemented by January 1, 2005 but is self-executing on this point.

To be entitled to the exemption the company that receives the dividend must hold the stock of the company paying the dividend without interruption for at least one year. The European Court of Justice established in the past that the minimum holding period requirement need not be satisfied at the time the dividend is paid, in a sense that the benefit is accorded even if at the time of the payment of the dividend the stock has been held for less than one year, provided that the one-year holding period is completed sometime afterwards. This rule is reflected in the language of the Italian statutory provision granting the exemption referred to above.

With resolution n. 109/E of July 29, 2005 the Italian tax administration clarified that if the one-year holding period has not completely run at the time the dividend is paid the withholding tax must be collected and paid. Once the one-year period is satisfied at any time after payment of the dividend, the taxpayer can apply for a total refund of the withholding tax. This position is clearly unfavorable to the taxpayer, considering the time needed to obtain a refund of the tax. Furthermore, the tax administration failed to clarify whether the taxpayer is entitled to interest for the period between the collection and the refund of the withholding tax and its final refund.

TAX ADMINISTRATION PROVIDES CLARIFICATIONS WITH RESPECT TO THE GENERAL EXCEPTION TO THE APPLICATION OF ITALIAN THIN-CAPITALIZATION RULES.

Under the rules of Tax Code article 98, deduction for interest paid or accrued on debt held or guaranteed by a related party is denied if the borrower’s debt-to-equity ratio exceeds a minimum threshold (computed both at the general level and at the level of each related party lender or guarantor). Nondeductible Interest on debt directly held by a related party is re-characterized as dividend for Italian tax law purposes. A general exception to the application of the thin-capitalization rules applies whenever the borrower is able to furnish sufficient evidence that the loan granted or guaranteed by a related party can be justified on the basis of its own credit capacity, as reflected by its total net worth, and would have been granted also by third parties acting at arm’s length. Circular 11/E of May 17, 2005 clarified that, for the purpose of this general exception to the rules, net assets must be computed at fair market value and that the borrower’s net worth includes also potential gains, assets and liabilities connected with arrangements and undertakings entered into; the exception automatically applies in case of debt raised through the issuance of debt obligations, in the light of the civil law limits to the issuance of debt obligations, whose general effect is just that of preventing issuance of debt obligations by thinly-capitalized or financially incapable companies; and the condition for the exception is presumed to be satisfied when a loan is granted with a pledge of the borrower’s shares as the only collateral.

With resolution 113/E of August 8, the tax administration clarified further that:

1. the mere circumstance that a bank or financial institution has confirmed that it would be available to extend credit to the borrower does not constitute by itself sufficient evidence of the borrower’s own credit capacity that triggers application of the exception;

2. the mere existence of built-in gains in some of the company’s assets, even if certified by an expert, is not a proof of a sufficient net worth, which must always be considered as a whole and with regard also to potential assets and liabilities that may arise from existing arrangements or contractual relations;

3. existing extensions of credit from banks or financial institutions, even if not used by the borrower, are a specific and good evidence of the borrower’s own credit capacity that may lead to the application off the exception.

The topic of Italy’s thin capitalization rules is discussed in general terms in Issue # 1 of our International Tax Newsletter and will be the subject of a more extended article to be published soon on TNI.

CLASSIFICATION AND TREATMENT OF NONBUSINESS ENTITIES AND CHARITABLE ORGANIZATIONS UNDER ITALIAN TAX LAW

Entities whose principal activity is a nonbusiness activity, i.e. an activity that is not carried out for the purposes of dividing the profits derived therefrom among the entity’s members, are classified as noncommercial entities for tax purposes. Noncommercial entity’s taxable income, if any, is computed in the same as the income of individuals and is taxed upon the entity at the ordinary corporate income tax rate (currently, 33 per cent). Dividends and capital gains from sale of stock may benefit from the participation exemption regime. In this event, 95 per cent of the amount of the dividends and 60 per cent of the amount of the gains are tax exempt.

If certain requirements are satisfied, a noncommercial entity can acquire the legal status of charitable organization (nonprofit organization of social value, or ONLUS) and enjoy a special tax treatment. If ONLUS status is achieved, income derived from the entity’s institutional activities and directly related activities is exempt from tax. Institutional activities are activities carried out in direct furtherance of the entity’s charitable purposes; directly related activities are activities connected with or incidental or instrumental to institutional activities mainly aimed at obtaining funds to finance institutional activities. Directly related activities cannot be prevalent compared to institutional activities and revenue generated therefrom cannot exceed 66 per cent of entity’s total expenses. Organizing public fundraising events and soliciting gifts and bequests are treated separately. Funds raised through occasional public fundraising and gifts and bequests are nontaxable. Unrelated taxable income is computed in accordance with the general rules applicable to noncommercial entities.

The distinction between institutional activities and directly related activities is at the core of the ONLUS status and requires a facts-and-circumstances case-by-case analysis.

Thanks especially to a comprehensive reform of the rules that apply to nonprofit organizations and the introduction of the special tax exemption treatment for charitable organizations the nonprofit sector in Italy has seen a boom in recent years. As a tradeoff, the level of scrutiny on charitable organizations is higher than in the past and managements costs have increased due to the careful planning and extensive accounting that are required to maintain such treatment.